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Full-reserve banking UPSC NOTE

 

  • Full-reserve banking, also known as 100% reserve banking, is a banking system where banks are not allowed to lend out money from customers' demand deposits.

  • Banks act as custodians to depositors' money under full-reserve banking, holding all money they receive as demand deposits in their vaults at all times.

  • Unlike the current banking system, under full-reserve banking, banks do not pay interest to customers on their demand deposits.

  • Banks are required to hold reserves backing 100% of their liabilities in the form of demand deposits to ensure they can meet redemption demands from depositors and prevent a run on the bank.

  • In a full-reserve banking system, banks can only lend money received as time deposits from customers.

  • Time deposits are funds that customers can withdraw from the bank only after a predetermined period, as agreed upon with the bank.

  • Banks use time deposits to lend to borrowers at a specified interest rate, collect repayments, and eventually return the deposited money to customers along with interest.


 


  • In the current banking system (fractional- reserve banking), banks mainly keep cash deposits from customers in their vaults and lend money electronically rather than in physical cash.

  • Banks can create electronic money by opening loan accounts for borrowers and crediting them with the loan amount, even if it exceeds the actual cash in their vaults.

  • Banks face the risk of a run if many borrowers decide to withdraw their electronically loaned money in cash, as the bank may not have enough physical cash to meet the demand.

  • Bank runs rarely happen because most transactions occur through non-cash instruments, reducing the need for cash withdrawals. 

  • Additionally, central banks provide emergency cash to bail out banks in times of crisis.

Comparison

  • Under full-reserve banking, banks are prohibited from issuing loans without actual cash to back them.

  • Some economists argue that banks issuing loans without sufficient cash should be considered fraudulent, while supporters of fractional-reserve banking disagree, believing it can stimulate investment and economic growth.

  • Supporters argue that fractional-reserve banking frees the economy from relying solely on real savings from depositors to fuel growth.

  • Advocates of full-reserve banking claim it is the natural form of banking, preventing crises and minimizing the risk of bank runs.

  • Full-reserve banking restricts banks from creating money, which proponents argue prevents artificial economic booms and busts associated with changes in money supply.

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Learnerz IAS | Concept oriented UPSC Classes in Malayalam: Full-reserve banking UPSC NOTE
Full-reserve banking UPSC NOTE
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